Point ofViewOur Perspective on Issues Affecting Global Financial Markets

July2008

PAGE1Going for Gold:

China and the Olympics

PAGE4 Global Inflation Fears:

Avoiding Past Mistakes

PAGE9 Profiling the European

Consumer: Differences between East and West PA

GE12 Sitting on a Mountain of

Cash: Corporate Liquidity and the US EconomyIn this Issue »

On August 8th, 2008, at 8:08AM, the 29th Olympi-ad, also known popularly as the Olympic Games, will commence in Beijing, China. As may be appar-ent, the Chinese con-sider the number eight fortuitous, and fortune is certainly what the Chi-nese government hopes to achieve in hosting the Olympic Games this year. In this article we will look at the money behind the current games and pro-vide a historical perspective on the business of the Olympics.

The History of the Olympic Franchise

The Olympic Games were born in ancient Greece in 776 B.C. Then, as now, the Games were held once every four years and included participants from most of the Greek city-states. The Olympiads were considered a time of respite from constant conflict—even city-states openly at war with one another would put aside grievances to compete in tests of speed, agility, and strength. The Olympics were hosted in this way until A.D. 393 when Ro-man emperor Theodosius, a Christian, prohibited the games on the premise that they were pagan in nature.

The Games were revived in 1896, when the first modern Olympics were held, appropriately, in Athens, Greece. Initial-ly, the Games were not very commercial. Na-tions willing to host the Games were expected to finance the construc-tion of athletic facilities through public finances. Taxpayers did not seem to mind, as the Olympics

were initially on a much smaller scale and brought international prestige to the host country. How-ever, by the 1976 Montreal Games, the production costs had climbed. Canadians today continue to pay a portion of their cigarette taxes to pay down the debt incurred by the 1976 Games, despite the comment at the time by the mayor of Montreal that “the Olympics can no more have a deficit than a man can have a baby.”1

The first Olympic Games to depend on corporate sponsorship for the majority of their financing were the 1984 Los Angeles Games. Under the di-rection of Olympic Commissioner Peter Ueber-roth, the first privately-financed Olympic Games resulted in a surplus of more than $225 million. Despite that initial commercial success, private financing of the Games has actually turned into

Going for Gold: China and the Olympics

a quixotic adventure, both for the cities and the companies involved.

Most Games since 1984 have been money-losing experiences for their host cities, and the trend seems to be accelerating. A notable example is the recent 2004 Games in Athens, Greece. In 1997, when Athens secured the role of host city, initial cost projections came in at $1.3 billion. By the time the Games were over, the cost had risen to nearly $14 billion—equivalent to about 2.5% of Greece’s gross domestic product (GDP) and enough to push the budget deficit above the 3% of GDP ceiling permitted under the euro zone stabil-ity and growth pact.2 Security alone cost the Ath-ens Games $1.5 billion dollars—more than what many earlier Games had cost in their entirety.

This is not to say that the benefits of the Games are entirely financial. Barcelona and Sydney were practically reborn as cities and as tourist destina-tions by their hosting of the Games. In the pro-cess of creating its Olympic venues, Barcelona was able to renew an entire section of the city that had decayed into slums. Sydney used the Games as an opportunity to brand itself as “the World’s City.” London is attempting to strengthen its own image as a global city in the same manner by hosting the 2012 Summer Games.

Despite the costs, even Athens benefited from its Games. The city has a new public transport sys-tem, which has eased traffic in one of the most congested cities in Europe. But in order to host a profitable Olympiad, a city has to not only manage costs, but also to control sponsorship revenues and take a long-term view in building Olympic facilities so that they will continue to serve useful purposes long after the Games have come and gone.

Marketing the Beijing Olympic Brand

This brings us to the Beijing Games of 2008. The Chinese seem to have absorbed many of the les-sons the Greeks had to learn the hard way. The Chinese are likely to spend a more modest $5-10 billion in producing the venues for the Games (although “total costs” —including cleaning up streets, reducing air pollution, improving public

transportation—may come closer to $40 billion).

According to the Beijing Olympic Committee (Bo-goc) website, a total of 31 Olympic venues will be ready come August, with the largest venue, The National Stadium (site of the opening and closing ceremonies), “covering an area of 20.4 hectares and seating 91,000 spectators in three floors.”3 In addition, many of the Olympic venues are “non-permanent,” meaning lower maintenance costs for facilities after the Games are over.

A large part of the money to pay for the games will come from fees for television rights and sponsor-ships. More than 60 official sponsors will line up to spend hundreds of millions of dollars merely for the right to spend millions more associating their brands with the world’s biggest sporting event.4 Sponsorship activity for the Games has been di-vided into several layers, varying in expense and prestige.

Inking a deal with the International Olympic Committee (I.O.C.) has long been considered the more lucrative move by those companies that plan to market during the Olympics for the long haul. These are companies that have been advertising for years in the Olympics and have become, over the years, nearly synonymous with the Games to American television viewers: Coca-Cola, McDon-ald’s, Lenovo and Visa all have deals with the I.O.C. which give them the right to use the Olym-pic rings worldwide in their advertising.

Below this level are companies interested in deal-ing directly with the Olympic organizing commit-tee in the host country. These companies are look-ing to get their messages to attendees by branding the venues, referees jerseys, and souvenirs. At the lowest level, each national team or national com-mittee has its own sponsorships, as do some indi-vidual athletes. This can lead to conflicts of inter-est with, for example, an athlete winning a medal for the 100 meter dash wearing Adidas shoes to run his race, but then being required to change into Nikes in order to mount the podium and re-ceive his medal.5

The Bogoc has taken several steps to strengthen

2 Payden & RygelJuly 2008

and protect its control of marketing during the Games. While China may be famous for weak in-tellectual-property rights, in 2002 the country ad-opted a law to specifically cover the use of Olym-pic symbols. In addition, athletes and coaches will have to agree not to lend their images to market-ing campaigns without the prior approval of the Bogoc. The Chinese government is also making efforts to let smaller companies know about the rules it has established for marketing during the Games so that infractions are kept to a minimum.

Guerilla Advertisers Crash the Party

Despite all of Bogoc’s preparations, however, a ma-jor threat to the main lines of sponsorship this year will come from guerilla advertisers, who attempt to ride the wave of Olympic fever, while trying to avoid paying any sponsorship fees to either the I.O.C. or the Bocog. Three main types of guerilla advertising have been attempted in the past and are expected again this year: advertising a product near (but not in) the Olympic venues; coordinat-ing branded clothing by spectators; and what can be called “indirect” association of a brand with the Olympics.

Advertising a product within the general vicinity of the Olympics has long been a difficult practice to control, especially in nations with limited gov-ernment control over advertising markets. In Chi-na the government exercises tighter control over these markets, and it has already announced that from July 11th through September 17th, it will re-strict the use of billboards within proximity of the Olympics venues and give advertising priority to official sponsors.

Within the venues, the issue is one of controlling the unintentional television exposure of audienc-es to unofficial brands. Examples would include footage of coaches who wear jackets with brand names on them that are not official sponsors of the games, athletes who use sports equipment im-printed with a non-sponsor’s name or trademark, and even audience members wearing the cloth-ing of a non-official sponsor. Bogoc has officially announced, with regard to the last of these, that security will act quickly to stop any attempts by

“coordinated groups of spectators [to wear] uni-forms or branded clothing in Games venues this August.”6

The third form of guerilla marketing, known as indirect marketing, is much harder to control be-cause it is more difficult to identify in the breach. Companies will attach themselves to the general feeling of pride a nation may be experiencing at playing host to the Games and use that posi-tive spirit to generate sales. As an example, while McDonald’s is an official sponsor of the Beijing Olympics, Kentucky Fried Chicken (KFC) in Bei-jing is promoting an “I Love Beijing” campaign in the city to coincide with the Games. While no direct mention is made in the advertising material to the Olympics, it is clear that KFC is attempting to leverage off the enthusiasm of city dwellers for the event.

Despite the political turmoil that has surrounded this year’s Summer Olympics, including the Chi-nese government’s handling of the Tibet issue and the fallout from the earthquake rescue operations in late May and early June, the expectation is still that the Beijing Olympics will be a huge success. Billions of people will be tuning in at some point during the Games, not only to cheer for their na-tion’s athletes, but also to see what kind of a show the Chinese have put on. If the authorities can manage to keep a tight rein on costs, while effec-tively controlling and enforcing their marketing and sponsorship guidelines, the Games may finally bring China the international respect, attention, and success, it has sought for so long. n

Notes: Stephen Evans. “The Olympics and the need to make 1. money.” BBC News Online. July 6, 2005.

Kerin Hope. “After the Olympics bash, the big 2. hangover.” Financial Times. August 31, 2004.

Victor D. Cha. “In China, the game has changed.” Los 3. Angeles Times. June 15, 2008.

“Thirty-one Beijing venues ready for Olympic Games.” 4. Xinhuanet. May 19, 2008.

Geoffrey A. Fowler. “Beijing Tightens Olympics-Ad 5. Grip.” Wall Street Journal. June 4, 2008.

Joe Nocera. “These Games Brought to You by…” The 6. New York Times. June 1, 2008.

3Payden & Rygel July 2008

The usual trip to the grocery store has become a lesson in the economics of inflation. Picking up a loaf of bread, a dozen eggs, and a gallon of milk to wash it all down with is considerably more expensive than it was just a year ago. In fact, the price of this small basket of goods has risen from $5.99 in June 2007 to $7.07 in June 2008. Add in the gallon of gasoline your car consumes on the roundtrip and the total expense of your brief shopping excursion has risen more than 20% over the past year.

Price increases of this magnitude are not just a US phenomenon. The impact of rising food and energy prices has been felt globally. Indeed, lorry drivers in Spain and the United Kingdom have been striking over the rising cost of diesel fuel and there has been social unrest over soaring grain prices in countries across the developing world. Yet key measures of inflation suggest that outside of food and energy, price increases have been relatively benign, at least in the industrialized world. This has led some economists to conclude that the current bout of inflation is less worrisome than that which arose in the 1970s when the rising cost of food and energy led workers to demand higher wages and thereby fueled a broad-based inflation.

However, the same may not be true in some emerging markets. Food and energy prices make up a much larger share of consumer expenditures in these countries and central banks do not have the same credibility when it comes to fighting inflation. Consequently, there is a higher risk that

the rising costs of food and energy will translate into increased wage demands and a wage-price spiral. Below we will take a closer look at these issues and discuss whether there are any signs of relief on the inflation front in the foreseeable future. Don’t Economists Eat and Drive?

Consumers are often frustrated by economists who claim that, outside of food and energy, inflation pressures are relatively contained. But that is exactly what government statistics indicate. The

Global Inflation Fears: Avoiding Past Mistakes

Headline Consumer Price Index (CPI)

Source: International Monetary Fund

3.9

2.2

6.3

4.7

2.6

7.4

0

1

2

3

4

5

6

7

8

World Industrialized economies Emerging and developing economies

Yea

r-to

-Yea

r P

erce

nt C

hang

e

2007 2008

23%$9.15Total Cost of Trip

32%$3.16Gallon of Regular Unleaded Gasoline (3.8 litres)

10%$3.43Gallon of Whole Milk (3.8 litres)

15%$1.19

40%$1.37Dozen Large Grade A Eggs

Loaf of White Bread

ChangeJune2007

A Trip to the Grocery Store in the US

2233%%$$99..1515TTotalotal CCosostt ooff TripTrip

3232%%$3$3..1166GalloGallonn ofof RegulaRegularr UnleadedUnleaded GasolineGasoline (3(3..88 litreslitres))

$11.24

$4.17

$3.77

$1.37

$1.92

June2008

4040%%$$1 31 377D LD L G dG d A EA E

ChangeChange20072007

$$1 91 922

20082008

Source: Bureau of Labor Statistics

4 Payden & RygelJuly 2008

headline consumer price indexes (CPIs) in the US and euro zone are running at, or just above, 4% year-to-year. Yet core inflation rates, which exclude food and energy, are roughly half that level. So what gives?

The textbook definition of inflation is an increase in the general price level for all goods and services. This must be distinguished from a rise in the price of a particular item, such as groceries or fuel, which represents a relative price change that may be driven by supply and demand factors in a specific market. Economists are primarily concerned about changes in the general price level that are not reflective of fundamental factors because they can lead to misallocations of resources due to the incorrect price signals they provide to consumers and producers.

The main reason why consumers may confuse a relative price increase with a more general inflation is the frequency with which they purchase an item. For example, consumers focus on items they purchase daily or weekly, such as gasoline and groceries, both of which are increasing at a rapid clip. However, lower frequency purchases, including automobiles, furniture and electronics equipment, have all been declining in price over the past year. Most importantly, shelter costs are increasing at their slowest pace in more than two years as bloated inventories of unsold homes increase the supply of rental units in the aftermath of the housing bust. The check written to the landlord once a month consumes approximately one-third the average household’s budget

compared to one-fifth that goes toward food- and energy-related products.

Nevertheless, consumers remain distraught over rising food and energy prices and they have called on policy makers to help them with their plight. Unfortunately, central bankers have little influence over the factors, such as weather or geopolitical events, which drive these prices. Put simply, a central bank can’t increase crop yields or extract more oil from the ground by adjusting interest rates. Therefore, policymakers have concentrated their efforts on preventing higher commodity prices from filtering through to the broader price level. The typical transmission mechanism by which this has occurred in the past is through consumer expectations and increased wage demands.

The Wage-Price Spiral of the 1970s

A so-called wage-price spiral unfolds when workers insist on pay increases to compensate them for a decline in real incomes driven by higher food and energy prices. Once a relative increase in food and energy prices becomes embedded in inflation expectations and higher wages, the general cost of all goods and services begins to rise because labor costs account for an average of two-thirds of the cost of production. This pattern was evident during the Great Inflation that gripped the industrialized world in the aftermath of the first oil shock in the early-1970s. During that period, double-digit inflation rates were not uncommon in the US and Europe.

The situation was aggravated by central bank policy makers who accommodated a budding wage-price spiral with extremely low real interest rates. Former US Federal Reserve Chairman Arthur Burns, who headed the central bank from 1970 to 1978, provides the most glaring example of the damage this flawed strategy can cause. The Burns Fed decided to slash the federal funds rate from a peak of more than 9% in 1969 to 3.75% in 1971 to ease the economic drag of rising food and energy prices.1

5Payden & Rygel July 2008

Fed Chairman Burns argued that monetary policy was an ineffective means for dealing with cost-push inflation driven by wages. Instead, he was a proponent of wage and price controls to combat what he referred to as the monopoly power of labor unions and corporations. President Richard Nixon initially imposed a 90-day freeze on prices and wages in August 1971 which was eventually extended to 1,000 days. Unfortunately, preventing prices from rising reduces incentives for producers to increase supply and for consumers to curb demand which prolongs the imbalance that pushed prices higher in the first place.

Thus, it is not surprising that the controls failed and a double-digit inflation ensued as average hourly earnings climbed higher and higher. The combination of high inflation and low nominal interest rates meant that real borrowing costs were extremely low. Initially, economic growth surged at annual rates of between 5% and 10%. But the payback came at the end of the decade with stagflation –the poisonous combination of declining economic activity with high inflation.

A Flashback to the 1970s Unlikely for Industrialized Economies

Some analysts have compared the recent inflation episode with the 1970s, noting both periods involved spiking commodity prices, rising inflation expectations and slowing economic activity. However, even a cursory look at key economic indicators in the United States and Europe suggests the comparison is grossly exaggerated.

During the mid-1970s, the US economy was shrinking at an annual rate of nearly 5% as higher energy prices led to increased wage demands fueling double-digit increases in both headline and core inflation. Today, by contrast, while headline inflation has drifted higher, core inflation has remained relatively well anchored due to modest growth in wages. Furthermore, economic growth as measured by real GDP has remained positive up to this point.

There are several factors that suggest a repeat of the 1970s-style inflation in the industrialized world is unlikely. First and foremost, food and energy make up a smaller share of the consumer basket in industrialized economies than they did three decades ago. In the United States, for instance, groceries and gasoline make up 18% of the average household’s spending today compared to 27% in 1975. Consequently, proportional increases in food and energy prices may not be having as large of an impact on consumer inflation expectations and wage demands as they had in the past.

The more limited power of trade unions may also be playing a role here. In 1975, approximately 29% of the US labor force was unionized compared to just 12% at the end of last year. Not surprisingly there have been fewer work actions or strikes and

The Stagflation of the 1970s Bears Little Resemblance to Today

-11.4%-14.0%S&P 500 Stock Index (Y/Y Chg)

4.1%7.7%10-Year Treasury Yield

2.0%5.8%Federal Funds Rate

1.0%-4.7%Real GDP (Q/Q annualized)

3.4%8.1%Average Hourly Earnings (Y/Y Chg)

5.5%8.6%Unemployment Rate

2.4%11.3%

4.9%10.5%Headline Consumer Price Index (Y/Y Chg)

Core Consumer Price Index (Y/Y Chg)

TodayMarch1975

Key US Economic Indicators

4 94 9%%1010 5%5%HeaHeadldliinene CConsumeronsumer PPrriicece IInnddexex (Y/Y(Y/Y ChChgg))

yy

Sources: Bureau of Labour Statistics, Bureau of Economic Analysis, and Federal ReserveNotes: The most recent monthly data available was for June 2008. Quarterly data is for the first quarter.

6 Payden & RygelJuly 2008

pay settlements have been lower for the most part. Indeed, average hourly earnings for the manufacturing sector are growing at a year-to-year rate of 3.5% today compared to growth of 8% or more in the 1970s. The same is true in the euro zone, though to a lesser degree. For example, 35% of the German labor force was unionized in 1975 compared to 22% today. At the same time, average hourly earnings growth in the manufacturing sector has slowed from 12% in the 1970s to below 3% today.

A third factor that has reduced the risk of a wage-price spiral forming is the improved inflation fighting credentials of central banks in the industrialized world. The recent decision by President Jean-Claude Trichet and his colleagues at the European Central Bank (ECB) to raise interest rates in early July to combat inflation in the face of slowing economic activity illustrates the commitment to price stability. This willingness to sacrifice economic growth in order to contain inflation has enhanced the ECB’s credibility and tempered consumer inflation expectations.

Although the Federal Reserve has not raised interest rates given the fragile state of the US economy, it has stepped up its hawkish rhetoric to assure the markets that inflation remains a top priority. Fed policy makers cautioned that “the upside risks to inflation and inflation expectations have increased” after their June 25

policy meeting.2 This signaled to investors that the Fed is not complacent about inflation risks and is prepared to act, though no such action is likely in the immediate future. Economic slack is increasing as the unemployment rate rises and capacity utilization falls in the manufacturing sector. This hardly seems like the backdrop for a wage-price spiral.

Emerging Markets Face Greater Risks While the risks of a major inflation outbreak in the industrialized world seem small, the same cannot be said for emerging markets where the circumstances are eerily similar to those that sparked the Great Inflation of the 1970s. Inflation rates are already uncomfortably high in many emerging markets. Double-digit price increases are already a reality in Indonesia, Russia, Saudi Arabia, South Africa, Turkey and Venezuela.

And official statistics in certain countries, including China and India, may be understating inflation pressures because governments have responded to price increases with price controls and export bans on items that are in short supply. Unfortunately, as the US experience of the early 1970s demonstrates, this strategy is doomed to failure because it aggravates the underlying imbalance that drove the price increases in the first place. Part of the problem in emerging markets is that

US Consumer Spending on Food and Energy is Less That it Once Was

Source: Bureau of Economic Analysis

1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

16%

18%

20%

22%

24%

26%

28%

Pe

rce

nt o

f Tot

al C

onsu

me

r S

pend

ing Food and Energy Spending as a Percentage of Total Consumer Spending

7Payden & Rygel July 2008

food and energy prices make up a much larger share of consumer expenditures in these countries. Indeed, food alone accounts for roughly one-third of consumer spending in the developing world versus about half that amount in the industrialized economies. In certain countries, such as India, spending on food can consume as much as 60% of the household budget.

To make matters worse, central banks in emerging markets do not have the same credibility when it comes to fighting inflation as their counterparts in the industrialized world. Consequently, there is a higher risk that the rising costs of food and energy costs will translate into increased wage demands and a wage-price spiral. This is already the case in China and Russia where wages are growing 20% to 30% per annum.

Central bank independence in these economies is severely constrained and real interest rates are far too low given the pace of economic growth. The Russian economy is growing in excess of 8% while Chinese economic growth topped 10% and yet real borrowing costs are either flat or negative in these countries. Although the Chinese economy still has a degree of spare capacity due to high rates of investment in recent years, the Russian economy has no such cushion and is at risk of overheating.3

Exporting Inflation?

What does this mean for the industrialized world? In the short-term, slowing global demand suggests that a pullback in food, energy and other internationally-traded commodities is possible and even probable at some point in the next year. Nevertheless, rapid growth in emerging markets implies that commodity prices will continue to rise in the long-term.

Beyond food and energy, there is concern in some quarters that the burgeoning wage-price spirals in emerging markets may lead them to export inflation globally. However, such fears are overblown since it is still cheaper to manufacture most goods in emerging markets due to their

lower cost structure, specifically with regard to labor which accounts for approximately two-thirds of manufacturing costs. Wages in places such as China, Brazil, Mexico, and Poland are one-third or less of US or European levels.4 Perhaps the bigger risk from rising inflation in emerging markets is civil unrest in these countries as relative living standards fall. Policymakers in the developing world need to get a handle on their inflation problems lest they repeat the mistakes that led to stagflation in the industrialized world in the 1970s. n

Notes: Robert L. Hetzel. “Arthur Burns and Inflation.” 1. Federal Reserve Bank of Richmond Economic Quarterly. Volume 84/1. Winter 1998.

Federal Open Market Committee. Policy Statement 2. from June 25, 2008 Meeting.

“Inflation in Emerging Market Economies: An Old 3. Enemy Rears Its Head.” The Economist. May 24, 2008.

International Comparisons of Hourly Compensation 4. Costs in the Manufacturing Sector. US Bureau of Labor Statistic. January 2008. http://www.bls.gov/news.release/pdf/ichcc.pdf

8 Payden & RygelJuly 2008

It has been nearly two decades since the fall of the Berlin Wall that separated Eastern and Western Europe. Since that time, the two regions have become much closer culturally, politically and economically. Many former Eastern Bloc countries have even joined the European Union with plans to become part of the single currency. However, there are still profound differences between East and West.

Nowhere is this more evident than in the consumer markets within the two regions. Eastern Europe is an emerging economy with 300 million potential consumers. The majority of the population falls into the lower income category, but there is a burgeoning middle class and a high concentration of wealth among the ultra-rich. Although household consumption in the region tends to be weighted toward essential items such as food, the middle and upper income groups are beginning to impact spending patterns.

Western Europe, by contrast, is an advanced economy with nearly 400 million consumers. The consumer market is characterized by a large middle class, paired with a smaller low income population and an even smaller share of the population that is ultra-rich. Discretionary items such as recreation and entertainment comprise a larger share of the consumer basket and the middle class tends to

dictate overall spending patterns. Below we will explore the differences between consumers in Eastern and Western Europe in greater detail. We will also discuss the opportunities the two markets present for future growth.

Measuring the East-West Divide

Any discussion of consumer behavior should be-gin with an examination of income and its dis-tribution. Per capita incomes in Western Europe were roughly $26,000 when measured at purchas-ing power parity in 2005.1 This is roughly three times higher than the $8,500 average per capita income in Eastern Europe. Certain countries in the region, including Hungary and Poland, are a little better off. However, even in these instances,

Profiling the European Consumer: Differences between East and West

The West Spends More on Discretionary Items

Source: EuroStat

0%

10%

20%

30%

40%

50%

60%

UnitedKingdom

Germany France Hungary Poland Bulgaria RomaniaPer

cent

age

ofD

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e Food and Beverages

Recreation and Culture

9Payden & Rygel July 2008

per capita incomes are only one-half or two-thirds of the Western European average.

Income distribution is also much more skewed in the East than in the West. The Gini coefficient is a ratio often used by economists to measure the level of income disparity in a country. It ranges from 1 to 100: the higher the number, the greater the disparity. Countries like Norway and Sweden, with Gini coefficients of about 25, have a more even income distribution than Turkey and Russia (approximately 40). Many countries in Eastern Europe fall in the 35+ range, while Western Euro-pean countries generally score below 30.2

Both the level of income and its distribution im-pact consumer behavior. Based on the available data, the average Western European spends about 15% of his or her income on food and non-alco-holic beverages, while the average Eastern Euro-pean spends about 30% and, in some extreme cas-es, as much as 50% of their disposable incomes on such items. If expenses on transport and utilities are included, the average Western European con-sumer has about two-thirds of his or her dispos-able income to spend on a variety of discretionary items, while the average Eastern European has less than half.

The greater amount of discretionary income in Western Europe probably explains the more wide-spread ownership of computers, mobile phones and other electronics equipment in the region. There were 421 computers for every 1,000 people in the European Union in 2004 and nearly 98% of citizens had a mobile phone in 2005. The num-

bers are dramatically different in Eastern Europe where there were only 98 computers for every 1,000 people and about 62% of the population had a mobile phone. These aggregated numbers hide the fact that the upper echelon in Eastern Europe lives as well, if not better, than their counterparts in the West. For more than twenty years, Forbes Magazine has been compiling a list of the people who really “made it”: the billionaires list. To get a sense of the seismic shift in wealth going on, one needs to look only at the relative difference between the list 10 years ago and today. In 1998, there were four Eastern Eu-ropean billionaires on the list: three from Turkey and one from Russia. Today, in a list that contains quite a few more: there are over 70 Russian names on the list alone! How does Western Europe fare? The number of Westerners on the list in 1993 was 54, with Germany being the top country with 18, France with seven, and the UK with six. Ten years later, the number has decreased to 49, with a simi-lar geographic distribution.3

The newfound wealth in countries such as Russia prompted the development of an annual trade show for the wealthy called the Millionaire Fair. Attendees can rub shoulders with Russia’s newly minted multimillionaires (and some billionaires) for a fee of €30. Items that sold at last year’s event included seven exclusive €1.3 million Bugatti cars, 15 GoldVish luxury cell phones costing up-wards of €350,000, and a Bovet watch at a cost of €450,000.

Catering to the Consumer

While Western Europe offers a wide array of shop-ping outlets catering to everything from the bare-bones necessities to the luxurious high-end, the most successful Eastern European retailers have emphasized the low-cost, discount model epito-mized by Aldi and Lidl in Germany, Asda in the UK, and Costco in the United States. Among the more successful stories: Turkish deep-discount food retailer Bimas and Russian dairy company Wimm-Bill-Dann.

Bimas was founded in Istanbul in 1995 and has grown to over 2,000 stores today. It had annual

10 Payden & RygelJuly 2008

sales of $2 billion in 2007, up 25% from the year before. Russian-based company, Wimm-Bill-Dann was formed in 1992 and had annual sales of $2.4 billion, which was up 33% from the prior year. For many in the West, it is easy to take for granted a product seemingly as simple as yogurt. But the variety of yogurt products available in the West was virtually unknown in most of Eastern Europe until the company started offering some of its star brands, including the “Happy Milkman,” “Our Doctor,” and, naturally, “Frugurt.” The company has shown that the region’s markets promise sig-nificant growth to business that might be viewed as mature elsewhere.

Which Markets Hold the Most Promise?

The Western European consumer market is much larger than that in Eastern Europe when mea-sured on the basis of the number of euros spent. Indeed, Germany’s €310 billion consumer market is more than five times larger than Poland’s—the largest Eastern European economy.

Yet, in terms of opportunity, the Eastern Europe-an consumer market is growing at a much more rapid clip, and that trend is expected to continue. Over the past five years, real consumer spending has averaged year-to-year growth of 6.1% in Po-land and 11.6% in Russia. The comparable figures for the euro zone (the group of countries that use the euro as their currency) was 1.6% during the same period.

For the moment, lower incomes in Eastern Eu-rope imply that spending patterns are dictated by needs rather than wants. This suggests that com-panies that target consumer staples are probably better positioned for the current market than those that depend on discretionary spending. However, this is already changing as is evident in the spending habits of the small, but growing class of ultra-rich. Over time, incomes across the region will rise and the disparity between the rich and poor will shrink. This will open the door to global retailers who are seeking to take advantage of the region’s burgeoning middle class. At some point, the only thing distinguishing consumers in East-

ern and Western Europe may be the language that they speak. n

Notes:Per Capita GDP is converted to international dollars 1. using purchasing power parity rates. An international dollar has the same purchasing power over GDP as the US dollar has in the United States. Data are in constant 2000 international dollars.

World Development Indicators2. , 2007. World Bank.

Luisa Kroll. “The World’s Billionaires.” Forbes. March 3. 15, 2008.

Consumer Spending is Growing More Rapidly in the East

Source: National Statistics Agencies

0%

2%

4%

6%

8%

10%

12%

14%

16%

09/03 12/03 03/04 06/04 09/04 12/04 03/05 06/05 09/05 12/05 03/06 06/06 09/06 12/06 03/07 06/07 09/07 12/07 03/08 06/08

Yea

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Euro Zone Real Consumer Spending

Polish Real Consumer Spending

Russian Real Consumer Spending

11Payden & Rygel July 2008

One word defines the latest business cycle: imbalances. Two imbalances immediately come to mind: households borrowed and spent lavishly, but probably saved too little, while corporations saved plenty, but probably invested too little. Both imbalances defy economic logic.

Households, many with a Baby Boomer closing in on retirement at the helm, ought to be saving more. Instead, the personal savings rate, which averaged around 8% of disposable income for most of the post-war era, has steadily declined since the mid-1990s and is now close to zero. Rather than save, households have borrowed heavily from the credit markets to finance their spending. Household debt rose to more than 125% of disposable income as consumer spending peaked at 72% of gross domestic product (GDP) last year.

Corporations, by contrast, have been very frugal, saving a large portion of their earnings and spending less on business investment.1 The total liquid assets of the nonfinancial corporate sector more than doubled over the past decade, peaking at nearly $1.6 trillion in 2007. Yet business investment, which was growing at an annual clip in excess of 10% for most of the 1990s boom, has averaged less than half that pace in the current cycle.

Policymakers are hoping to encourage businesses to loosen their purse strings and spend some of their cash hoard amid the recent slowdown in the US economy. Households, which have been the key driver of economic activity in recent years, are looking increasingly tapped out due to the combination of rising unemployment, record high gasoline prices and declining home values. Below we discuss some of the reasons for corporate thrift as well as the prospects that the cash will finance a business-led economic recovery.2

Corporate Shift from Net Borrower to Net Lender

The money and capital markets play a critical role in our economic system, linking together those with excess savings (lenders) with those in need of money (borrowers) via financial intermediaries (e.g., commercial banks and investment banks). For most of the post-war era, the nonfarm nonfinancial corporate business sector has been a net borrower in these markets. In other words, savings fell short of capital expenditures. That is because businesses typically borrow money to invest and produce goods and services. The extent to which borrowing by corporations exceeds their profits is known as the “corporate financing gap.” This gap peaked at a record -$310 billion in 2000.

Sitting on a Mountain of Cash: Corporate Liquidity and the US Economy

The Pile of Corporate Cash

Source: Federal Reserve

Nonfarm nonfinancial corporate business - Total Liquid Assets

1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 20060

0.2

0.4

0.6

0.8

1.0

1.2

1.4

$1.6

Tril

lions

of U

S D

olla

rs

12 Payden & RygelJuly 2008

Interestingly, something changed around the start of this decade: the corporate finance gap reversed. Instead of acting as borrowers in the capital markets, nonfinancial corporations became net lenders. That is, instead of selling stocks, bonds and money market instruments to fund business investment, the corporate sector instead accumulated financial assets.

Firms also boosted their liquidity positions by extending debt maturities during the 2000 to 2005 period, replacing shorter-term debt with longer-term debt to become less dependent on short-term market financing. As a percentage of total liabilities, short-term debt dropped from about 35% to 25% in 2005. As corporations cleaned up their balance sheets, overall corporate debt growth also slowed. The nonfinancial corporate sector accumulated credit market debt at an average annual rate of just 2% between 2002 and 2004, the slowest pace since the early 1990s and the second slowest period since World War II.

So, from 2000 to 2005, corporations stopped tapping the capital markets, shunned short-term debt and dialed back overall debt growth. Meanwhile, corporate profits surged as labor productivity outpaced compensation growth. In fact, corporate profits as a share of national income

rose to a record high of 14% in 2006. But rather than expand operations or invest these profits in new technology, businesses used the excess cash to accumulate financial assets on a massive scale.

Stuffing Cash under the Proverbial Mattress?

While it is pretty clear how corporations accumulated the cash, it is less definite as to why. Explanations abound, but we can narrow them into three key categories:

precautionary, reactionary, and a lack of alternatives.

Precautionary motive: Corporations shifted their focus to liquidity in the wake of defaults in the commercial paper market after the bursting of the technology bubble in 2000 by reducing reliance on short-term debt markets. Concerns about the economic environment and access to credit may have prompted firms to seek more liquid assets on their balance sheets. Looming geopolitical risk associated with the 9-11 terrorist attacks and the Iraq War during the 2001-2003 period did little to allay concerns and may have contributed to corporate thrift and caution.

Reactionary motive: Stung by a period of rampant overinvestment in the bubble years of the late 1990s, businesses recoiled during the early phase of the recovery. Empirical evidence suggests that when highly-leveraged positions are unwound, they have a substantial impact on investment activity going forward.3 Further, the weakness of the economic recovery at the beginning of the decade discouraged hiring and investment. In this view, firms accumulated cash not as a cushion, but as a consequence of overinvestment. Lack of Alternatives: With interest rates near historic lows, it is hard to imagine an environment better suited for investment opportunities.

13Payden & Rygel July 2008

Instead, corporations demonstrated the desire to hold financial assets rather than make business investments. This could signal that corporate managers saw a distinct lack of opportunities and preferred to sit on the sidelines and wait. Unleashing the Corporate Largesse

Even as they shied away from capital expenditures, corporations splurged on stock repurchases. In fact, by the fourth quarter of 2007, net new equity issuance declined at an annual rate of just over $1 trillion as shares were effectively removed from circulation. It is also worth noting that share repurchase activity encompasses more than just companies buying back shares, it also includes private equity activity (which retires

shares) and merger activity which also picked-up. Nonetheless, the net new equity issuance decline is unprecedented.

In this light, the rise of corporate cash serves as a reminder that household and corporate decisions are intricately linked. Corporations’ share repurchase activities represent “resource transfers” to other sectors of the economy. In fact, one of the biggest net “sellers” of equities since 2000 has been US households, whose equity holdings declined from about $10 trillion in the first quarter of 2000 to about $5 trillion in the first quarter of 2008. This channeling of resources to

the household sector may have increased personal consumption and reduced the need for private sector savings.4

Interestingly, corporations also chose to buy back stock shares rather than retire debt. Total credit borrowing levels continued to rise—albeit slowly early in the cycle. However, firms began raising money again in the capital markets—with the growth in commercial paper, corporate bonds and bank loans accelerating in the first quarter of 2006 and continuing through the first quarter of 2008. Cash generated by firms went to line the pockets of shareholders rather than to reduce short-term debt or eliminate obligations all-together.

The Impact on Economic Activity: Yin and Yang Effect

Will the corporate cash build-up persist and how will it impact the economy? To gain perspective, consider that a $1.6 trillion cash stockpile is 10 times the size of the Federal government’s 2008 fiscal stimulus scheme.5 Surely, corporations could spur more economic activity than tax rebate checks from the Internal Revenue Service. What is more, with the media abuzz over worries about a credit crunch cutting off the supply of credit to the economy, corporations sit on a massive pool of in-house cash financing available for investment,

Corporate Profits Share of National Income Rises Sharply

Source: Federal Reserve

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

62%

64%

66%

68%

70%

72%

74%

As

A S

hare

of N

atio

nal I

ncom

e

2%

4%

6%

8%

10%

12%

14%

As a

Sha

re of N

ationa

l Income

Corporate profits (Right)

Compensation of employees (Left)

14 Payden & RygelJuly 2008

mergers or acquisitions and even more buy- backs.

Unfortunately, economists have been anticipating a meaningful upturn in capital investment for years. In 2005, Alan Greenspan noted that “although capital investment has been advancing at a reasonably good pace it has nonetheless lagged the exceptional rise in profits and internal cash flow.”6 A renewed boom in business investment failed to materialize. In fact, the high flyer in terms of business investment has really been investment in commercial real estate, which has been running at a double-digit pace over the last several quarters. And here is where basic economics again intrudes: it is unlikely that business investment will surge if consumer spending softens. Consumer demand for products ultimately drives investment and production—not the other way around.

In the meantime, stockholders may remain hopeful that as equity valuations decline, buy- back and merger activity appear more attractive. Bondholders should also take comfort that the cash hoard and cleaned-up balance sheets may prevent widespread corporate bond defaults as the economy falters.

As the economist Herb Stein said, “Anything that can’t go on forever, won’t.” The corporate cash stockpile simply represents another example of this imbalance phenomenon—one which will not go on forever. What seems likely is a gradual shift toward more household savings (a sign of household deleveraging) and a gradual drawdown in corporate cash as profit growth continues to slow. n

Notes: For the purposes of this article, corporations refer to 1. nonfarm, nonfinancial corporate businesses. Financial corporations have also been accumulating savings, but this appears to be a longer-term trend established in the 1990s. This trend is apparent across many of the G-7 although here we focus on the US.

Rich Miller. “Bernanke, Greenspan Agree Cash Arms 2. Firms for Slump” Bloomberg.com. April 14, 2008.

“When Bubbles Burst” World Economic Outlook, April 3. 2003. the International Monetary Fund, Chapter II.

“Awash in Cash: What Has Been Driving The Increase 4. in Corporate Excess Saving?” World Economic Outlook, International Monetary Fund 2004, 139.

Roben Farzad. “$1.6 Trillion. Now We’re Talking 5. Stimulus.” BusinessWeek. February 6, 2008.

Alan Greenspan. Testimony before the Committee on 6. Banking, Housing, Urban Affairs in the US Senate, Federal Reserve’s semiannual Monetary Policy Report to Congress February 16, 2005.

15Payden & Rygel July 2008

Payden & Rygel’s Point of View reflects the firm’s current opinion and is subject to change without notice. Sources for the material contained herein are deemed reliable but cannot be guaranteed. Point of View articles may not be reprinted without permission. We welcome your comments and feedback at editor@payden-rygel.com.

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